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More than a decade ago, the largest retailer in the world went to market with the tag line: "Watch Out for Falling Prices." Beginning in the early 1980s, a decade of inflationary economic policies was squeezed out of the economy by an aggressive anti-inflationary Federal Reserve. Retail was hit particularly hard. Consumer demand shrank during the 1980-82 recession, retail bankruptcy rose and a more price-sensitive consumer came out of the recession looking for bargains.

After the 1980-82 recession, a generation of retail executives grew up in an environment of falling prices that was driven by increased supply chain innovation coupled with growing globalization. Profit growth had to come from productivity gains and new store openings. The consumer got an increasingly better deal while retailers were able to grow their own profitability. That era is now over.

Inflation gets built into an economy when wage costs rise faster than productivity. In the past two business recoveries, rising unit labor costs prompted the Federal Reserve to raise interest rates to dampen inflation. With unit labor costs up 4.8 percent from a year ago, the Fed is now cutting rates. The result has to be higher inflation.

The last two recoveries endured for nearly a decade, in large part because inflation was kept low by strong productivity gains. While productivity growth was robust at the beginning of the current recovery, it has waned in recent years. Despite record gains in profitability, business investment in productivity-enhancing software and equipment has been mediocre the past few years. With business investment growth weak, productivity growth has slowed, giving rise to labor costs.

Consider this: Against the backdrop of the Long Term Capital Management crisis in 1998, gold hit a low of $260 per ounce, oil traded at $14 per barrel and the British Pound was worth $1.65. In this environment of low inflation, the Fed was in a position where they could cut rates aggressively without fear of rising inflation. Currently, gold is over $700 per ounce, oil is just under $80 per barrel, and the Pound trades for $2.04. Against this backdrop, any cut in interest rates is very quickly going to have an inflationary impact, and nowhere is that more apparent than in food prices.

Food Prices and Margins
% Change, Year-to-Year

Source: Bureau of Labor Statistics and Deloitte Research

Food prices in August were up 4.2 percent from a year ago, the fastest rise in prices in more than a decade. At the same time, food margins have taken a recession-like dive. A weak dollar and generous ethanol subsidies are raising the cost of goods sold for food. The challenge for food retailers is that during periods of rising food inflation, consumers become much more price-sensitive in their buying habits. As a result, rising costs are harder to pass along in the form of rising prices to consumers.

Implications for Retailers
Cutting interest rates in the face of rising labor costs is a sure recipe for higher inflation. In bailing out the credit markets, the Fed has built higher inflation into the future outlook for the economy as a whole and the food business in particular. The biggest challenge for food retailers in a rising inflation environment has always been maintaining margins. Under these conditions, managing strategic pricing programs will become a critical priority for food retailers.

If you would like to comment or send us your feedback on this column, please send e-mail to csteidtmann@deloitte.com.